Bank of America's Legal Liability Is About to Soar

There is little doubt that it is a positive move for Bank of America (NYSE: BAC) to bring Merrill Lynch into the family fold, a merger that will save money and break down the wall that still seems to exist between the two.

As B of A absorbs Merrill's assets and liabilities, however, investors should be aware that the latter is substantial, particularly in one area: representations and warranties concerning past sales of mortgage-backed securities, claims against which are cropping up more often lately.

Lawsuits are piling upMerrill's 10Q form lays out the problems it faces from unresolved reps and warranty claims against MBSes it sold in the 2000s. As of June 30 of this year, Merrill's estimated liability for unresolved repurchase claims from private investors was $7.2 billion. Adding in claims from monoline insurers and Fannie Mae and Freddie Mac bumps the number up to $7.4 billion. Merrill notes that another $1.2 billion in claims stem from a servicer Merrill believes has no valid claim.

That's quite a bit -- and it looks like it could get worse. As of December 2012, Merrill's liability in this area stood at only $5.8 billion. The bank notes that it expects these private-label claims to increase, as well.

At minimum, it seems, Bank of America can expect to immediately add another $7.4 billion to its MBS liability levels once Merrill Lynch is fully integrated. That's on top of B of A's own stated $16.6 billion in liability, which, at least, dropped from $28.3 billion at the end of 2012. Similar to Merrill, however, Bank of America notes some additional claims of $1.5 billion, which the bank claims have no merit.

MBS woes are widespread for big banksThis problem is not limited to Merrill and B of A, though Countrywide has added a layer of mortgage-based turmoil to the latter that other banks haven't experienced. Still, peers JPMorgan Chase (NYSE: JPM) and Wells Fargo (NYSE: WFC) haven't escaped the ire of investors, mortgage insurers, or government-sponsored entities, either. At a mere $2.2 billion estimated liability for unresolved claims at the end of June 2013, Wells is easily dwarfed by B of A, as is JPMorgan, which declared a comparable amount of $2.4 billion at the end of June. For Wells, management attributes its low liability to the fact that the bank has stayed away from the subprime mortgage market, though it admits that originations dated from 2006 to 2007 are still considered high-risk.

For JPMorgan, however, private-label repurchase liabilities are not folded in to that number, and the bank estimates that the total value of the securities involved in various lawsuits filed by private investors total $166 billion -- which means its liability will likely be much higher than just $2.4 billion.

Bank of New York Mellon settlement: Still up in the airThe biggest wild card for Bank of America remains the Bank of New York Mellon (NYSE: BNY) case. This settlement between B of A and 22 institutional investors regarding a slew of Countrywide MBSes gone bad is being reviewed by the New York Supreme Court, which is scrutinizing whether or not trustee BNY Mellon acted "reasonably" under New York's Article 77 law governing such settlements.

If the court decides BNY did not fulfill its responsibilities toward the investors, the entire $8.5 billion settlement, forged in 2011, could be thrown out. That would put Bank of America in the precarious position of possibly paying quite a lot more to settle the case than it had originally planned.

How much more? That is unknown, but B of A is concerned -- so much so, that it listed the possibility that the case might be struck down in its "Risk Factors" section on its last 10-K form. The bank notes that it estimates additional liability to be about $4 billion above its year-end reserves.

According to some experts, however, that estimate could be a little low. Back in February, CSLA analyst Mike Mayo opined that the big bank may need closer to $30 billion; others, like Mark Palmer of BTIG Research, thinks $60 billion is closer to the mark.

So, while another $7.4 billion added to Bank of America's liability sheet might seem tiny, it is just one of many additional burdens the big bank will have to bear. And no one -- not even B of A itself -- knows how many more will be coming down the pike any day now.

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Fool contributor Amanda Alix has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, JPMorgan Chase, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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